How does industry risk impact business valuation?

There’s a trade-off between risk and return in business valuation. Investors expect to receive a higher return as the company exposes them to greater risk. Industry-specific risk is an important consideration when estimating an investor’s expected return. Here’s how business valuators measure industry risks and factor them into their analyses.

Assessing industry risks

Virtually every business valuation report includes a section on industry risks. Several factors are used to measure industry risk, including:

Growth prospects. Evaluate the industry’s future outlook, including its seasonal and cyclical trends and stage of development. For example, emerging industries typically grow faster but face greater uncertainty than mature industries. Strong, predictable growth prospects generally equate with lower industry risk and higher value.

Relative power of suppliers and customers. Look up and down the company’s supply chain to determine which players have the greatest negotiating power. For example, the subject company may be at the mercy of vendors if it operates in an industry dominated by a few key suppliers that provide value-added services (as opposed to price-sensitive commodities). Supply chain partners with more power — or supply chains with balanced power — tend to have less industry risk.

Competitive threats. When sizing up the competition, consider geographic location and market position. For example, you obviously wouldn’t compare a fast-food taco truck to an upscale five-star restaurant. Large industry segments characterized by intense global price competition are particularly risky.

Risk of product substitution. Evaluate whether customers could use another readily available, less expensive product in lieu of the subject company’s offering. If customers can easily switch to a substitute product, the industry’s risk is greater.

Barriers to entry. More is at stake when companies participate in industries that require licensing, expensive outlays for equipment, compliance with stringent regulatory requirements and continual investments in technology or research and development. To illustrate, investors typically demand a higher return for investing in a high-tech manufacturer than in an educational services provider.

Valuators use several resources to assess industry risks, including the company’s business plan, industry trade associations and fee-based external sources. Examples include Duff & Phelps’ Annual Valuation Handbook, IBISWorld’s Industry Research Reports, First Research’s Industry Profiles and Risk Management Association’s Annual Statement Studies®.

Factoring industry risk into value

Once a valuator understands the subject industry, he or she can evaluate management’s cash flow predictions. For example, a valuator may question how realistic it is for management to forecast a 10 percent growth rate if the industry is declining and management hasn’t taken steps to transition the company’s offerings to changing consumer demands.

Likewise, when selecting comparables from public stock markets or private transaction databases under the market approach, it’s important to know where the subject company fits within its industry in terms of size, financial performance, capital structure and market position. Some comparables may be eliminated based on the industry risk assessment — or an industry-based risk adjustment might be factored into the valuator’s application of pricing multiples.

Under the income approach, the company’s discount rate (also known as its required rate of return) may be adjusted up (or down) depending on how risky the company’s industry is compared to the overall market. This adjustment can be made if the appraiser uses the capital asset pricing model or the build-up method to estimate the subject company’s discount rate.

Also, under the income approach, industry risks come into play when estimating the company’s long-term sustainable growth rate. Valuators generally assume that the subject company’s growth will someday even out to a moderate, steady rate into perpetuity. In turn, this growth is used to compute capitalization rates under the income capitalization method and terminal value under the discounted cash flow method.

Getting a handle on industry risks

Industry risks impact the value of a business in many subtle ways. Accurate valuations hinge on taking the time to understand the subject industry thoroughly and where the subject company fits within that group.

Defining the subject industry

Appraisers typically define industry in terms of Standard Industrial Classification (SIC) or North American Industry Classification System (NAICS) codes. However, it’s critical to research the companies that fall under the same code to ensure that they’re truly comparable to the subject company.

Sometimes, the code management uses on its tax return is outdated or inaccurate. For example, SIC codes haven’t changed since 1987 — when business was conducted without the Internet, cell phones or nearly as many environmental regulations. Many industries have changed dramatically over the last few decades. Other new industries have emerged. But few established companies have bothered to revise their old SIC codes.

Often companies dabble in more than one industry, making accurate comparisons difficult. This industry overlap may be true of large public conglomerates or companies that are vertically integrated, such as a manufacturer that also distributes or services its products.

Clients and attorneys can help appraisers select an appropriate subject industry. In doing so, evaluate whether the industry description accurately depicts what the subject company does. There should always be a clear link between the subject company and the comparable data underlying the valuator’s industry risk assessment.

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